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Sub-prime woes pose questions for managers

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To date some 287 federal cases related to the sub-prime crisis have been filed by unhappy investors in the US.

To date some 287 federal cases related to the sub-prime crisis have been filed by unhappy investors in the US. While there is no doubt that some hedge funds will be ensnared and implicated in some of these lawsuits, it’s a fallacy to hold hedge funds wholly responsible for this crisis.

Responsibility for securitising and rating mortgage-backed transactions lies with the investment banks and rating agencies, and most hedge funds are only investors in these securitised transactions. Some of the lawsuits seek to implicate hedge funds, but the problems lie clearly on the origination side of the mortgages and with the poor due diligence by the rating agencies and investment banks.

Valuation is another important issue facing all hedge funds, and mortgage-backed and other illiquid assets, such as small-cap equities, can be very hard to value. Model-based valuations are no substitute for market-led ‘willing buyer, willing seller’ priced transactions. Hedge funds are finding it increasingly difficult to value problematic assets, and when faced with significant redemptions, the only viable option is to liquidate the fund and close the business.

There is also the matter of governance and the role played by fund directors. Many ‘career’ directors have had it too easy for too long, and it is questionable whether they truly understand the new and complex accounting rules coming into play. In today’s litigation climate, disgruntled investors are likely to sue fund directors as well as the managers themselves.

Career directors who are simultaneously overseeing tens of funds while spending much of the week on the golf course are especially at risk. Managers need to rethink seriously the key role of fund directors and adopt best practice to appoint truly professional and knowledgeable directors with no conflicts of interest.

The credit crisis is a very serious problem for hedge funds and funds of funds. With investment banks sitting on hundreds of billions of dollars of write-downs in their own trading and non-trading books, the natural thorough reassessment of credit lines to funds is having a contagion effect on the industry.

The US Federal Reserve’s recent rate cuts were designed to boost the economy, but Japan’s experience in the 1990s suggests that control of the money supply through lower interest rates might not be the only stimulus needed. Many banks and funds are tapping sovereign funds for a bailout.

Meanwhile, many managers with funds that have so far focused purely on the US are already in London or considering setting up offices there to access UK, European and Asian market opportunities.

Sigma Partnership is well placed in London to offer comprehensive specialist advice to inbound managers seeking to build their UK and European businesses. The firm’s partners have solid investment banking backgrounds and eschew the checklist-based methodology of other boutique consulting firms. Drawing on its professional knowledge and understanding of the needs of hedge funds, Sigma Partnership assists its clients in the areas of regulatory compliance, accounting, taxation and governance.

Sigma pioneered a series of monthly briefing notes in 2006 on issues of topical interest to managers, investors, participants and other service providers. The current distribution figure is over 1,000 and many notes are subsequently redistributed by recipients such as law firms. Topics have ranged from the need to change limited partnership agreements under new accounting guidelines and MiFID regulation to taxation and governance issues.

Joe Seet is the senior partner of Sigma Partnership

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